SEC, CFTC blame algorithm for ‘flash crash’

Two liquidity crises caused stocks’ short-lived plunge on May 6

By

RonaldD. Orol

WASHINGTON (MarketWatch) — A massive, automated trade drove two liquidity crises and created the “flash crash” on May 6 that rattled markets and upended investor confidence worldwide, according to regulators Friday.

The Securities and Exchange Commission and Commodity Futures Trading Commission released a long-awaited report that comes in the wake of the Dow Jones Industrial Average’s
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sudden drop of nearly 1,000 points on May 6. At one point that afternoon, the Dow dropped 481 points in six minutes and then had recovered 502 points just 10 minutes later.

Specifically, the report points to a large fundamental trader, which it doesn’t identify, that executed a large sell order -- valued at roughly $4.1 billion -- using an automated execution algorithm at a time in the afternoon while the markets were already very stressed. Read the full summary of the SEC-CFTC report.

Waddell & Reed
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has been widely blamed for setting off the flash crash with this trade, though they were not specifically named in the report. In May, the Overland Park, Kan.-based mutual-fund and asset-management firm said it had not intentionally disrupted the markets. SEC and CFTC staffers declined to comment on whether they were conducting an enforcement investigation into the large trader’s massive order. One CFTC staffer said that it was an “unfortunate” selection of time to place the trade because the markets were already under stress.

The report’s release puts a spotlight on securities and futures regulators’ inability to oversee the exploding trading world of super-fast computers and hundreds of new ways to execute transactions — all of which has left retail traders frustrated and disoriented.

“There is no smoking gun.”
Adam Sussman, director of research at TABB Group

“The SEC and CFTC report confirms that faster markets do not always lead to better markets,” said House securities subcommittee chairman Paul Kanjorski (D., Pa.). “While automated, high-frequency trading may provide our markets with some benefits, it can also carry the potential for serious harm and market mischief.”

He added that to bolster investor confidence, the agencies and Congress must review and revise the rules governing market structure.

According to the report, the combined selling pressure from the huge order drove high-frequency traders to drive down the price of the E-Mini S&P 500 futures market at the same time as it drove the liquidity providers and market makers to withdraw from individual stocks. The confluence of events in the afternoon came as the market already was experiencing an unusual volatile day, the report added. See external link to the flash crash report

“[High Frequency Traders] in the equity markets, who normally both provide and take liquidity as part of their strategies, traded proportionally more as volume increased, and overall were net sellers in the rapidly declining broad market along with most other participants,” the report said.

The report also pointed out that only two single-day trades of equal or larger size, one of which were executed by the same large trader marked as a key contributor to the flash crash, were executed in the E-Mini market in the 12 months prior to May 6. However, no trade has happened of that size in such a short period of time in the past 12 months, a CFTC staffer said. According to the report, the larger trader sought to sell about 75,000 E-Mini contracts as a hedge to an existing equity position.

High frequency traders and market makers were the likely buyers of the orders. According to the report, these traders accumulated significantly large positions, but between 2:41 and 2:44 they ‘aggressively’ sold these positions, taking liquidity away from the markets.

The report follows up on a 151-page preliminary report released May 18, the SEC had argued that the plunge could have been due, in part, to the combination of a major drop in the prices of stock index products such as index exchange traded funds, the decline of E-Mini S&P 500 futures and “simultaneous and subsequent” waves of selling of stocks.

The SEC-CFTC report also singles out so-called stub quotes as a major problem on May 6. Currently, the SEC requires market makers — typically specialists at the NYSE Euronext’s
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New York Stock Exchange or the Nasdaq OMX Group’s Nasdaq
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— to have both a bid and an offer when they want to publish a quote.

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